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Analysis on the Chinese Enterprise Financing Abstract:The main sources of financing for small and medium sized enterprises (SMEs) are equity, trade credit paid on time, long and short term bank credits, delayed payment on trade credit a nd other debt. The marginal costs of each financing instrument are driven by asymmetric informatio n and transactions costs associated with nonpayment. According to the Pecking Order Theory, firms will choose the cheapest source in terms of cost. In the case of the static trade-off theory, firms cho ose finance so that the marginal costs across financing sources are all equal, thus an additional Euro of financing is obtained from all the sources whereas under the Pecking Order Theory the source is determined by how far down the Pecking Order the firm is presently located. In this paper, we argue that both of these theories miss the point that the marginal costs are dependent of the use of the fun ds, and the asset side of the balance sheet primarily determines the financing source for an additiona l Euro. An empirical analysis on a unique dataset of Portuguese SMEs confirms that the compositio n of the asset side of the balance sheet has an impact of the type of financing used and the Pecking Order Theory and the traditional Static Trade-off theory are rejected.

For SME the main sources of financing are equity (internally generated cash), trade credit, ban k credit and other debt. The choice of financing is driven by the costs of the sources which is primar ily determined by costs of solving the asymmetric information problem and the expected costs assoc iated with non-payment of debt. Asymmetric information costs arise from collecting and analysing i nformation to support the decision of extending credit, and the non-payment costs are from collectin g the collateral and selling it to recover the debt. Since SMEs’ management and shareholders are oft en the same person, equity and internally generated funds have no asymmetric information costs an

d equity is therefor

e the cheapest source.

1 Asset side theory of SME financing

In the previous section we have suggested that SME’s in Portugal are financed using internal g enerated cash, cheap trade credits, long and short-term bank loans and expensive trade credits and o ther loans. In this section the motives behind the different types of financing are discussed.

1.1 Cheap Trade credits

The first external financing source we will discuss is trade-credits. Trade credits are interesting

since they represent financial services provided by non-financial firms in competition with financia l intermediaries. The early research within this area focused on the role of trade credits in relation to the credit channel or the so called “Meltzer” effect and in relation to the efficiency of monetary poli cy. The basic idea is that firms with direct access to financial markets, in general large well known f irms, issue trade credits to small financially constrained firms . The more recent research breaks the role of trade credits into a strategic motive and financial motive for issuing and using these credits.

Strategic motives

The first theory centers on asymmetric information regarding the firm’s products. Trade credits are offered to the buyers so that the buyer can verify the quantity and quality before submitting pay ments. By offering trade finance the supplier signals to the buyers that they offer products of good q uality. Since small firms, in general, have no reputation then these firms are forced to use trade credi ts to signal the quality of their products. The use of trade credits is therefore driven by asymmetric i nformation of the products and is therefore more likely to be used by small firms, if the buyer has lit tle information about the supplier, or the products are complicated and it is difficult to asses their qu ality.

The second strategic motive is pricing. Offering trade finance on favorable terms is the same as a price reduction for the goods. Thus firms can use trade credits to promote sales without officially reducing prices or use them as a tool for price discrimination between different buyers. Trade credit s are most advantageous to risky borrowers since their costs of alternative financing are higher than for borrowers with good credit ratings. Thus trade credits can be used as tool for direct price discrim ination but also as an indirect tool (if all buyers are offered the same terms) in favor of borrowers wi th a low credit standing.

Trade credits are also used to develop long term relationships between the supplier and the bu yers. This often manifests itself by the supplier extending the credit period in case the buyer has tem porary financial difficulties. Compared to financial institutions suppliers have better knowledge of t he industry and are therefore better able to judge whether the firm has temporary problems or the pr oblems are of a more permanent nature.

The last motive in not strictly a strategic motive but is based on transactions costs. Trade credit s are an efficient way of performing the transactions since it is possible to separate between delivery and payment. In basic terms the truck driver delivering the goods does not have to run around to fin